Returns to Capital in Microenterprises

What are the returns to capital when it comes to microfinance? What are the effects of demand shocks, entrepreneurial ability, and other independent variables? Many in the microfinance (and enterprise development) communities have wondered about these very questions for years, but little empirical research has been done to support or reject working hypotheses. A recent paper by Stiglitz et. al. does tackle this issue, but so does a newly-released Working Paper.

Small and informal firms account for a large share of employment in developing countries. The rapid expansion of microfinance services is based on the belief that these firms have productive investment opportunities and can enjoy high returns to capital if given the opportunity. However, measuring the return to capital is complicated by unobserved factors such as entrepreneurial ability and demand shocks, which are likely to be correlated with capital stock. We use a randomized experiment to overcome this problem, and to measure the return to capital for the average microenterprise in our sample, regardless of whether or not they apply for credit. We accomplish this by providing cash and equipment grants to small firms in Sri Lanka, and measuring the increase in profits arising from this exogenous (positive) shock to capital stock. After controlling for possible spillover effects, we find the average real return to capital to be 5.7 percent per month, substantially higher than the market interest rate. We then examine the heterogeneity of treatment effects to explore whether missing credit markets or missing insurance markets are the most likely cause of the high returns. Returns arefound to vary with entrepreneurial ability and with measures of other sources of cashwithin the household, but not to vary with risk aversion or uncertainty.